How the Fed Prepared to Buy Bank Stocks in 2007: Street Whispers

Written by: Antoine Gara01/22/13 - 11:43 AM EST

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NEW YORK ( TheStreet) -- As the U.S. subprime housing market went into meltdown in 2007 and brought Wall Street to its knees -- leading to trillions in bailout measures -- some officials in the Federal Reserve were ready to buy up bank stocks.

Little did they know by 2008 it would be all but impossible for the Fed not to hold them despite stated policies against equity ownership.

While transcripts of meetings from 2007 released on Friday provide a glimpse into the Fed's slow recognition of the cracks in megabanks that would imperil the global economy, poorly timed comments like one governor's hypothetical recommendation to buy bank shares near pre-crisis stock highs also foreshadow the extreme and still unknown steps that the central bankers took to rescue Wall Street when the crisis hit.

According to transcripts from a Sept. 18, 2007 meeting, then-Governor Frederic Mishkin recommended that the Fed consider buying bank stocks given the bright long-term prospects of the financial sector, particularly in originating home loans if lending standards improved.

"In particular, we've gone to an originate-to-distribute model, which Fed Governor Randall Kroszner mentioned, and we have found some serious flaws in it. The expectation is that we will have new models coming out. In fact, I think that this is actually going to be a long-run profit opportunity for the banks. So if we were allowed to buy bank stocks, I think it would be a good idea," says Mishkin.

"Laughter," is the reaction of Fed officials to Mishkin's idea, according to the Fed's transcript .

Mishkin's recommendation was used as a hypothetical to describe the health of the U.S. financial system when early signs of crisis emerged. Still, it raises key unanswered questions from the financial crisis and the Fed's unprecedented action.

Notably, the mid-September meeting was the first where the Fed considered novel programs to dramatically expand its balance sheet and provide relief to America's largest banks and Wall Street dealers. Within months of the meeting, the Fed would be pumping trillions into the banking system and taking assets in return such as equities and complicated debt instruments it previously considered unacceptably risky.

While the Fed might not have bought bank shares as Mishkin recommended in 2007, it may very well have held them as collateral against emergency loans during the crisis.

At the Sept. 2007 meeting, one of the first to occur after clear signs of crisis emerged and propelled the central bank into action, Mishkin detailed his impressions of the potency of a housing market bust for the financial sector, characterizing it as somewhere between quick crises such as the failure of hedge fund Long Term Capital Management and the Sept. 11, 2001 terrorist attacks, and more structural collapses such as the savings and loan crisis.